Description

Summary

Founded in 1978 and headquartered in Coppell, Texas, The Container Store Group, Inc. (“the Company”, or “TCS”) is engaged in the retailing of storage and organization products in the United States.  The Company operates in two segments, TCS and Elfa. The Company’s retail stores provide products of various lifestyle departments, including bath, box, closets, collections, containers, food storage, gift packaging, hooks, kitchen, office, shelving, storage, trash, and travel, as well as its Elfa products.   

We believe that TCS operates in a commodity business with a slight differential to competitors, but not much.  In fact, we believe that the title and theme of this short should be “allege to build, and they will come.”  The Company came out on the heels of a hot IPO market that values “story” rather than performance.  We believe that TCS plays well in this market of “storied” stocks, since on the surface it has all of the variables to make executing on its growth strategy a success.  It has one of the top Board of Directors, including the co-CEO of Whole Foods and Danny Meyer, a well-known restaurateur.  The Company’s mantra revolves around “Conscious Capitalism” which also plays well to the target affluent, predominantly female, demographic.  Furthermore, its largest investor, Leonard Green & Partners (>57% of total shares), is also one of the world’s foremost and successful consumer-focused private equity funds, where it targets companies with the ability to grow cash flows by at least 50% over a five-year period.

We believe that Leonard Green will be pressured to sell stock as soon as its lock-up expires in late April as TCS has been a lackluster legacy 2007 investment.  At current market prices, its investment in TCS has been given a second chance to potentially earn a 25% IRR for the fund today rather than wait a couple of years to prove to new investors that TCS has growth potential.  The Company is also riddled with variable rate debt which could easily spike and pressure earnings.  Finally, in order to justify current valuation levels, the Company would need to execute a 300 store growth strategy over the next five years.  That would mean that it would need to build 5 stores per month through 2018.  This would be doable if it were not for the fact that TCS has never grown more than five store per year since 2000, or potentially since inception.  Moreover, the Company has stated that building new stores is very costly and that its above-average employee compensation structure will always pressure margins.  We value a perfect growth execution at $42 per share and an intrinsic value of under $20 per share.  Therefore, we are short the shares at prices above $42 per share, which should give us an adequate margin of safety.

Exhibit 1: TCS Current Market Overview

(See pdf write-up)

Business Overview

The Container Store was established with one store in Dallas, Texas in 1978.  Today its operations consist of two reporting segments: TCS and Elfa.  TCS consists of retail stores, a website and a call center.  Based on LTM 2013, the TCS segment had net sales of $646 million, which represented approximately 88% of total net sales.  Elfa, based in Malmö, Sweden, designs and manufactures component-based shelving and drawer systems that are customizable for any area of the home, including closets, kitchens, offices and garages.  In addition to supplying the TCS segment, which is the exclusive distributor of elfa® branded products in the United States, Elfa sells to various retailers and distributors in more than 30 other countries around the world on a wholesale basis.  Based on LTM 2013, the Elfa segment had $90 million of third party net sales, which represented approximately 12% of total net sales. 

As of November 2013, TCS operates 63 stores with an average size of approximately 19,000 selling square feet in 22 states and the District of Columbia.  In fiscal 2012, TCS net sales were derived from approximately 10,500 unique stock keeping units ("SKUs") organized into 16 distinct lifestyle departments sourced from approximately 700 vendors around the world.  In fiscal 2012, the TCS segment had net sales of $613 million, which represented approximately 87% of total net sales.

Company Timeline

• 1978: First store opened in Dallas, TX by Kip Tindall (current CEO) and Garrett Boone (Chairman Emeritus)
• 1991: Opened first out-of-state store in Atlanta, GA
• 1997: Became the exclusive distributor for Elfa storage product in US and Canada
• 1999: Acquired Elfa, the manufacturing and wholesale European subsidiary. Number of Company stores: 20
• 2003: Opened first Manhattan store
• 2006: Melissa Reiff named President; Sharon Tindell (Kip’s wife) named Chief Merchandising Officer
• 2007: Leonard Green & Partners (“LGP”) acquired a majority equity stake for approximately $370 million (~$455 total equity value; ~$755 total enterprise value).  Number of Company stores: 38
• 2009: Took a goodwill impairment charge on Elfa assets of $124 million
• 2012: Debt is refinanced, whereby a new $275 million Secured Term Loan was entered into, replacing the previously existing $125 million Secured Term Loan and $150 million Senior Subordinated Notes
• 2013: Company completes IPO and sells 14 million shares at $18.00 shares; restructures and retires high yielding preferred

Positives

Appealing Store and Product Offerings

The Container Store, in its entirety, has no direct competitor and only 63 stores nationwide.  The Container Store brand is synonymous with storage and organization, and carries with it loyalty from a shopping experience.  The CEO mentioned in his last letter that there is a “customer dance” that is felt at its stores.  We felt this too when we visited a few stores, and we agree that the store layout, location and customer service is extremely appealing and inviting.  However, there are many other furniture-related competitors with comparable offerings (e.g. “California Closets” or “Closets by Design” for Elfa; Bed, Bath & Beyond, Ikea, Target, etc. for TCS).  According to management and historical figures, the TCS store appeal has contributed to new store production four-wall first year EBITDA margins of 21%.  Management highlights its core customers are predominantly female, affluent, highly educated and busy.  JP Morgan research, further specifies: “The majority of customers are female, age 30-65, educated, ~half are married, and ~40% have children at home.  The average income is over $100K, with the average net worth at $450K.”  There are approximately 71 million females in the United States between the ages of 30-65; there are about 25 million households with incomes over $100,000 and ~10 million of those have children.

Our research and interviews with this demographic has shown that TCS is recognized as best-in-class store for home organization.  TCS offers good middle-of-the-road customizable offerings.  However, when asked how often they shopped at TCS, most agreed that it was infrequent but still recommended the store. 

Elfa branded closets makes up the largest merchandise percentage of revenue at 33% (13% is sold directly to external customers).  Exhibit 2 shows TCS’ merchandise distribution.  The remaining brands are for sundry storage-related merchandise. 

Exhibit 2: Merchandise Category as a Percentage of Total Net Sales

 Customer Focused Culture

TCS has an “employee-first” culture built around its Foundation Principles and Conscious Capitalism.  It is essentially a commitment to the organized lifestyle, robust training, and strong customer service level focus.  TCS hires only 4% of applicants, and has an average full-time employee turn-over rate of approximately 10% annually, much lower than the average retail industry.  Employees earn significantly more than the industry average (~ >50%) and receive a significant more amount of training in their first year of employment (>260 hours).  This highly paid, highly trained culture acts as a distinct “competitive advantage” in attracting customer purchases for organized products.  Employees are ambassadors for the Container Store brand as they interact with customers who place also place a high regard for an organized life. 

Steady Store Metrics

In February 2000, the Company had 20 stores (CA: 2; CO:1; FL:1; GA:2; IL/Chicago:4; TX:8; D.C.:2).  Since its founding in 1978, the Company had grown its stores base by about one store per year.  By fiscal year 2006 (February 2007), TCS had 38 stores in 17 different markets, growing its store base by about three stores per year for that period.  Since LGP’s investment, the Company has grown its store base by about four stores per year. 

We believe that, despite the financial crisis, the Company’s measured store growth has allowed it to hold its store productivity consistent at around $11 million per store since its fiscal year 2008 (see Exhibit 3).  We believe that the Company’s cultural strengths have contributed strongly to this trend.  We see this in pre-open costs per store increases of over 70% since 2011 – the Company has provided research analysts with metrics from 2008 through 2011, which we believe is not representative of more recent costs.  Pre-opening costs are expenditures associated with opening new stores and relocating stores, including rent, marketing expenses, travel and relocation costs, and training costs that are expensed as incurred rather than accounted for as capital expenditures. 

The Company discusses its new store execution when it mentions that its success rate is due in part to its new store opening execution strategy, which involves months of hiring, training and preparation and culminates in a multi-day grand opening celebration in partnership with a local charity.  Container Store donates 10% of the initial Saturday and Sunday sales to the charity.  We believe that in order to maintain this consistent productivity pre-opening costs might actually increase significantly from current levels, especially if it looks to grow its store base to 300 stores over the next five years.  This could potentially translate to around $7 million all-in costs per store over the long term. 

Exhibit 3: Store Metrics

Despite consistent productivity, the Company’s comps have declined sequentially since FQ1 2012, although some analysts are expecting a slight rebound with comps returning to 4.0%.  We think that this might be hard given that storage and organization is not as recurring in nature (noting that bespoke closets are the largest piece of net sales) as more general retail home-improvement stores. 

Exhibit 4: Quarterly Comparable Store Sales Growth

(See pdf write-up)

Strong Board Members

Many of TCS’ board of directors have strong consumer retail company franchise experience.  Walter Robb is currently co-CEO of Whole Foods.  Whole Foods is a leading specialty grocer that has successfully expanded while improving margins.  Whole Foods is considered the top company in the grocer/food industry.  On an interesting side note, it appears that William Tindell and John Mackey (co-founder of Whole Foods) might have been college roommates. 

Next, there are three Leonard Green board members who have extensive experience in growing consumer retail chain stores similar to TCS.  Leonard Green is considered one of the top performing PE funds in the world.  It has successfully invested in Whole Foods Market, J. Crew, PETCO Animal Supplies, BJ's Wholesale Club, Topshop, David's Bridal, Leslie's Poolmart, Jo-Ann Stores, Sports Authority, Savers, Neiman Marcus Group, Tourneau, Jetro Cash & Carry and The Tire Rack.  LGP’s investment philosophy is to target cash flow positive businesses that have the ability to grow by at least 50% over a five-year period.  Over the life of all of its funds, it has successfully executed on this philosophy.  Lastly, Danny Meyer, a top restaurant mogul, has considerable experience in growing “concept” companies. 

Exhibit 5: Management and Directors

Margins and Return Stabilization

The Company’s TCS segment has held EBITDA margins steady at around 10.5%, while consistently growing stores.  We view this segment as the driver of future growth in earnings.  Elfa has improved to -7% margins.  In a normalized setting, Elfa margins could improve to break-even levels. 

Returns (i.e. ROIC and ROEs) are harder to assess, since there have been significant “non-operating” adjustments in each year since LGP has owned the Company.  To adjust the numerator only without also historically “adjusting up” the denominator creates misleading returns figures.  Furthermore, if the adjustments had never existed it would still be hard to determine the correct “pro forma” capital management plan shareholders would have enacted.  The very fact that there were adjustments suggests that returns may not be that meaningful historically.  That said, we believe that the business has been improving operating returns, but at best has operated at 8% ROEs per year, which we believe is below its cost of capital.  As we will discuss more below, we believe that LGP would internally agree with this assessment, which we think was another motivating factor in taking TCS public.

Source: Company reports.

Unproven Significant Store Growth

The Company, on average, has never grown more than six stores per year or the equivalent of half a store per month since its founding in 1978 or since LGP did a buyout of the Company in 2007.  Although, LGP’s investment could be written off as an over-priced, over-levered pre-crisis LBO, we believe that post-crisis, the Company has still not been able to grow, as other consumer retail companies (e.g. Pier 1, Bed Bath & Beyond, Whole Foods, etc).  Even with LGP’s push during this period, the Company did not grow materially.  Valuation for this stock is dependent on the Company’s ability to significantly grow its store base to 300 stores over the next five years.  To grow to 300 stores from its current store base of 63, would mean about 4-5 stores per month or 48-60 stores per year.  We doubt that this can happen without affecting culture and brand.  For comparison, as of June 1, 2013, Bed, Bath, and Beyond operated 1,478 stores, including 1,008 BBB stores; 73 CTS stores; 48 Harmon stores; 83 BuyBuy BABY stores; and 266 World Market stores.

Interestingly, as we highlighted earlier, although productivity has held constant, comps have not been as consistent.  We believe that as the number of stores increases, the current demographic won’t necessarily increase purchases.  Adding more stores in current areas would saturate the “organization” market.  Furthermore, building new stores is very expensive if the Company plans to keep its culture intact. 

Commodity Product Offerings

We believe that the storage market is highly commoditized.  Generally speaking, customers have many choices between customized built-in closets or off the shelf solutions, such as Rubbermaid (sold through Amazon or Wal-Mart).    In addition to comparative shopping at other websites and stores, we would expect their targeted demographic to also access more expensive home renovation built-in options.  There are many specialized builders that serve this competitive niche, for example “California Closets”,  “Closets by Design,” and number of local/regional players.

Elfa May Continue to Face Challenges

Elfa is currently 33% of net sales.  External sales of Elfa were 12% of net sales and a negative contributor to profits.  Since the crisis, (i.e. fiscal 2008, 2010, 2011 and 2012) the Company’s Elfa segment has continued to experience a challenging economic environment in Europe, which has resulted in Elfa missing sales and profit plans.  The result has been dramatic goodwill and trade name impairment charges and restructuring the segment.  This segment has improved to unadjusted LTM EBTIDA margins of -7%, but if margins do not improve from here, there could be further significant intangible impairment charges or a sale of the segment entirely.  Even if revenues stabilize, it might be hard for it to return to meaningful profitability. 

Finally, it is interesting that as sales at Elfa have declined, inter-company sales to TCS have risen, which suggest that TCS is pushing this closet brand hard at its stores to make up for deteriorating external “standalone” sales.  Customers can only be pushed so hard into certain brands and solutions.  Again, we believe that if this continues, management will be hard pressed to take drastic restructuring measures.

LGP Overhang

In August of 2007, implied by Company filings, Leonard Green & Partners acquired a majority equity stake in TCS for approximately $370 million (~$455 total equity value; ~$755 total enterprise value).  We arrived at this using data as demonstrated in Exhibit 8. 

Exhibit 7: IPO Summary

Based on our analysis, up until 2013, LGP’s investment in TCS was less than lackluster, due to the crisis, overpaying for the business and asset write-downs.  However, the Fed’s QE and a hot IPO market for companies with store expansion “stories”, appears to have given LGP’s investment in TCS a second chance.  At the time of the IPO, initial PIK preferred investors (senior and junior) were owed nearly double what they put in.  The Company could pay any of the preferred investors in full.  As a result, preferred shareholders agreed to restructure their securities for an immediate cash payment and common equity swap.  The Company was in no cash position to make such a distribution, but the equity markets were.  In comes the IPO.  All of the proceeds in the equity offering were used to pay this restructuring distribution to the existing preferred investors and to pay down some existing senior debt.  No proceeds were used for growth capital.  If TCS is to grow to 300 stores, significant capital is still needed.  We believe that LGP is well aware of this fact. 

Exhibit 8: TCS Distribution and Common Share Exchange

From an outsider’s perspective, LGP still owns well over 57% of the Company, which means that LGP’s interest in TCS should theoretically align with new shareholders.  However, a closer look would suggest that this might not necessarily be the case.  Given what we know about their initial investment, distributions received, post-common shares owned and current stock price trading levels, it appears that LGP’s investment could finally be at respectable private equity returns of over 25% (see Exhibit 9).  At initial IPO prices of $18 per share, LGP’s investment is a 12% IRR investment, which might align interests as it would motivate LGP to prove the growth strategy to new investors.  However, we believe that post lock-up expiration, if TCS’ market prices continue at current levels, LGP could be heavy sellers of the stock.  Furthermore, LGP’s TCS’s investment is a vintage 2007 investment that will be close to seven years old, which will put added pressure on them to sell their TCS stake and “close the books” on all of their vintage 2007 investments so that they can focus on their latest GEI VI Fund. 

The Company has yet to prove that they can fully execute a growth strategy that has eluded them.  Regardless of whether TCS can or cannot execute its growth strategy effectively, they will need growth capital.  We believe that this capital will need to come from the equity markets, since they are highly levered for a retailer.   

Exhibit 9: LGP Potential IRRs

TCS is Highly Levered

As of August 31, 2013, TCS had pro forma total outstanding debt of $360.7 million and an additional $68.6 million of availability under the Revolving Credit Facility and the Elfa Revolving Credit Facility.  This is roughly 4.0x adj LTM EBITDA, 6.2x LTM EBITDA, 6.0x adj LTM EBIT and 12.8x EBIT.  Adding the additional capacity would suggest 4.8x adj LTM EBITDA, 7.4x LTM EBITDA, 7.1x adj LTM EBIT and 15.2x EBIT.  All of the debt is variable, so we believe that the Company’s interest payment burden might be understated over the medium-term.  TCS’ debt is rated B and is considered high yield.  The high yield markets as of late have been frothy.  TCS has used a favorable high yield market in 2012-2013 to refinance its existing term loan.  Although the market for high yield issuers has been favorable, we believe that equity investors should take note. 

Management Compensation

CEO William A. ("Kip") Tindell, III is married to Sharon Tindell, the Chief Merchandising Officer.  In fiscal 2012, the couple collectively earned $3.5 million, almost entirely in cash.  The performance based annual cash compensation, the largest contributor of their total compensation, is determined using a performance grid based on Adjusted EBITDA. In our opinion, this compensation is not as favorable as a return-based or margin based incentive structure, since there are many ways to potentially manipulate adjusted EBITDA and make it more of a “self-graded” test. 

Exhibit 10: Management Compensation

 (See pdf write-up)

Quality of Earnings & Corporate Governance

Currently the Company qualifies an emerging growth company under the Federal Jumpstart Our Business Act of 2012 (JOBS Act).  Under the JOBS act, the Company will not be required to engage an auditor to report internal controls over financial reporting.  We think this is odd, since TCS should not technically be considered as an “emerging” (founded in 1978), “growth” (has grown its store base at 2 stores per year since 1978) company.  Regardless, we believe that a public company should be in compliance with internal controls over financial reporting as soon as possible.  TCS has until the end of 2014 to be compliant.

Additionally, due to LGP’s majority interest, TCS is considered a “controlled company.”  Consequently, TCS qualifies for and intends to rely on exemptions from certain corporate governance requirements. For example, the Board of Director committees formed post IPO (audit, compensation, etc.) are not formed of solely independent directors.

Earnings Outlook

Our normalized earnings analysis consists of the following three scenarios by 2018: (i) 300 stores, which is management’s base case of 4 stores per month; (ii) 120 stores which is nearly 1 store per month; and (iii) 90 stores, which assumes TCS’ current historical growth rate of ~5 stores per year. 

In all scenarios, except revenue per share, the following modeling assumptions hold: 

• TCS revenue per store = $11 million; 12% TCS EBITDA margins
• Elfa revenue = $90 million per year; 2% EBITDA margins
• All-in new store costs = $7 million per store
• Existing store improvements per year = $500K per store
• Annual interest expense rate of 5.5% per year on $361 million of debt outstanding
• Tax rate = 38%
• Cash discount rate = 10%

Also, in all three scenarios we assumed that $67 million in unused debt capacity gets used.  The only difference for the second and third scenarios is that we assume that management is able to improve store productivity to $12 million and $14 million per store due to more measured growth execution.  Regardless, we believe that each scenario is aggressive in that not only would management need to execute a perfect strategy, but it also has to be able to converge adjusted EBITDA margins to actual EBITDA margins of 12% per year.  That might be difficult to execute consistently each year, since the Company touts that it has the highest compensation structure for employees and has additional spending as part of its “Conscious Capital” core principles. 

Valuation Analysis

Assuming perfect execution of a 300 store growth by 2018, we believe that the maximum price TCS should be worth is $43 per share, which is close to the stock’s current 52-week high.  We also assume that once it reaches its target, the Company could trade at more mature company multiples of 12x EBITDA which is also a somewhat aggressive trading range for mature companies (see Exhibit 13). 

Exhibit 11: Normalized Earnings Valuation Analysis (300 Stores by 2018)

We believe that at the very least management should be able to execute its historical annual store growth of 5 stores per year.  If it can execute on this strategy, then we believe that stock should be worth closer to $20 per share.  In all fairness, we think that this is likely achievable and that valuation, for now, should circle around this fair value. 

Finally, we calculated several sensitivity analyses that framed our upper and lower bounds.  In order for the stock to double from here, management would not only have to be able to execute a 300 store growth strategy, but it would also need to be able to improve and consistently maintain total company margins to 14-15% (reaching BBBY margins), lower store opening costs to $4 million per store and hope that debt interest rates remain under 5.5% every year or get refinanced prior to maturity.  In the 300 store scenario there would not be enough excess cash to pay down any long-term debt. 

Exhibit 12: Valuation Sensitivity Analysis

300 Stores by 2018

120 Stores by 2018

90 Stores by 2018

Exhibit 13: Comparable Home Improvement Retail Companies (raw data as it appears on databases)

(See pdf write-up)

Recommendation and Rationale

Risks

Near-term risks to the short investment include: 1) faster than expected store expansion; 2) improving profitability across segments; 3) sale of Elfa brand to “clean-up” growth story; 4) ceiling intrinsic values could have no upper bounds in the short-term because there are no current earnings and the market could create its own “imaginary” valuation levels .  Finally, TCS is being added to the Russell 1,000 index on December 20, 2013, which pressure the stock upward around and after that period. 

Management Questions

What is your long-term targeted store productivity?  What is your long-term target EBITDA margins?  How are you thinking about the variable portion of your long-term debt?  What is your long-term target Elfa EBITDA margins?

Catalyst